Junk bonds aren't quite the trash of the fixed income world of investing. In fact, buying the right junk bond fund can be a smart move for a diversified portfolio. Bonds are debt securities issued by corporations, governments, and municipalities and bought by investors.
Junk Bond Definition
Also known as high yield, junk bonds are bonds that have credit quality ratings below investment grade. This means they hold a rating below BBB by Standard & Poor's or below Baa by Moody's credit rating bodies. In contrast, bond ratings of AAA are the highest quality. A bond can receive a lower credit rating because of the risk of default on the part of the entity issuing the bond. Because of this higher risk, the body issuing these bonds will pay higher rates to offset the investor's risk of buying the bonds. This is where the name "high yield" comes in.
Think of one person's credit score. People with a poor credit record, or those whose finances are weak, will be given lower credit scores and will be charged higher interest rates when they borrow money. The same theory is followed by the bodies giving credit ratings to the bond-issuing entities. Poor credit in the past or weak finances equals higher rates for borrowers. In the case of bonds, the issuing entity is the borrower and the bond investor is the lender.
On the other hand, the high credit bonds are above investment grade. Entities with high ratings will be rewarded by paying lower rates when they borrow.
Investment Strategy, Timing and Risks
The basic reason for investing in securities with higher relative risk is simple. Higher relative risk can mean higher relative returns. Still, the world of fixed income is a complex one. The market risks of investing in junk bonds and high-yield bond mutual funds are fuzzy for a lot of people.
The Fed and Bond Prices
Bond fund prices are linked to interest rates and inflation. Bond prices move in the opposite direction as bond yields. Through the actions of the Federal Reserve, rates can be moved up or down. The Fed does this to slow down an intense economy or to spark a weak one. Rates often rise during times of strong economic growth and mostly decline in recessionary climates.
The Markets and Bond Prices
Investors and capital markets also affect bond prices and yields. People are not as willing to pay as much for a high-risk bond but they are willing to pay more for low-risk bonds. Think of times of recession, where the investor herd is moving away from what is seen as risky and toward what i seen as safe.
As more and more people demand "safety," when they invest, the demand pushes the safe investment product's price higher and its yield lower. People wanting low risk move to the safest investments with the highest credit ratings, such as U.S. Treasuries.
When economies begin to look healthy again, people start moving out of perceived safety and into higher-risk areas. This pushes the higher risk (i.e. junk bond) prices higher and the opposite occurs for the "safe" bonds. Interest rates (yields) move higher as prices decline due to lower demand by the investor herd. The lesson learned is that a loose and big-picture view for investment strategy is to be one step ahead of the herd and the Fed.
Prior to and during a recession, the high credit quality, low-risk bond funds—those investing in U.S. Treasuries and above investment-grade corporate bonds—can be a smart move. Toward the end of a recession, a person could begin shifting into the lower credit quality, high-risk junk (high yield) bond funds. The goal is to ride prices higher as the economy improves. Thus, the best time to invest in junk bonds is in the latter stages of a recession, right at the time when no one else wants them.
Mutual Fund Tips and Cautions
Due to the complex nature of bond investing and the risk of market timing, most people will do well investing in a bond fund with expert management. This way, you can leave the navigation of this complex credit world to those who know it best--the bond fund experts.
If your investment goals are at least three years or more away, and you want to gain exposure to high relative risk, you might look at a fund such as Loomis Sayles Bond (LSBRX), which can invest in almost any type of bond, including junk bonds, foreign bonds, and emerging market bonds.
Of course, even the best bond fund managers can make mistakes. Thus, you may want to look closer at some reasons why to use bond index funds.